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The Law and Economics of Costly Contracting
Alan Schwartz, Yale
Joel Watson, University of California, San Diego
ABSTRACT:
In most of the contract theory literature, contracting costs are assumed either to be high enough to
preclude certain forms of contracting, or low enough to permit any contract to be written. Similarly,
researchers usually treat renegotiation as either costless or prohibitively costly. This paper addresses
the middle ground between these extremes, in which the costs of contracting and renegotiation can take
intermediate values and the contracting parties can themselves influence these costs. The context for
our analysis is the canonical problem of inducing efficient relation-specific investment and efficient ex
post trade. Among our principle results are: (i) The efficiency and complexity of the initial contract are
decreasing in the cost to create a contract. Hence, the best mechanism design contracts can be too
costly to write. (ii) When parties use the simpler contract forms, they require renegotiation to capture
ex post surplus and to create efficient investment incentives. In some cases, parties want low
renegotiation costs. More interesting is that, in other cases, parties have a strict preference for
moderate renegotiation costs. (iii) The effect of Contract Law on contract form is significant but has
been overlooked. In particular, the law's interpretive rules raise the cost of enforcing complex
contracts, and thus induce parties to use simple contracts. Worse, the law also lowers renegotiation
costs, which further undermines complex contracts and is also inappropriate for some of the simpler
contracts.
SUGGESTED CITATION:
Alan Schwartz and Joel Watson,
"The Law and Economics of Costly Contracting"
(December 1, 2001).
Yale Law School.
Yale Law School John M. Olin Center for Studies in Law, Economics, and Public Policy Working Paper Series.
Paper 264.
http://lsr.nellco.org/yale/lepp/papers/264
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